Industrial Organization is the area of economics that studies the markets as institutions, the state of competition and strategic interaction among firms, the industrial policy and the business decisions firms make within the market framework. The course looks at the markets from three different perspectives: the economic theory, the applied business perspective and the institutional and legal perspective. The focus of the course is split equally between the economic theory and business perspective but there is a significant legal component incorporated in various topics. The course includes economic modeling, game theory, numerous real life examples and several case studies. We explore interesting topics of market organization such as negotiations, antitrust, networks, platforms, electronic markets, intellectual property, business strategies, predation, entry deterrence and many others.
The basic objective of the course is to enable the student to understand the structure of markets and the nature of strategic competition. Knowledge in this course will be valuable for the students in acquiring managing and governance skills, enriching their understanding of the institutional framework of business, and improve their analytical ability in negotiations.
Prerequisites: The course requires understanding of basic economic modeling, knowledge of intermediate microeconomics (especially production/cost theory), knowledge of basic concepts and methodologies of game theory, intermediate econometrics and basic calculus.
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From the lesson

Static competition

The topic of this lecture is short-run competition. That is, interaction that lasts only for one period. Static competition is not the most usual form of competition but it is not rare, either. Most of the principles that we will present in this lecture will carry over to the dynamic competition analysis later. There are two different kinds of static competition. The first is when strategic variables have a positive causative relationship, as in competition with prices. The second is when the strategic variables are negatively related, as in competition with quantities. We will cover interesting notions such as first-mover advantage, the Bertrand Paradox, capacity constraints, differentiated products, and will introduce the notion of collusion that will be of major importance for our future lectures.

Taught By

Kosmas Marinakis

Assistant Professor

Transcript

[MUSIC] The first way to resolve the Bertrand Paradox is by a assuming that we have capacity constraints. In other words, we cannot produce as much quantity as we want. There is a ceiling in production, that it's not possible for us to find the production factors or to find the time to produce as much quantity as it will be sufficient to cover the entire market. Now, capacity constraints are mainly imposed by the cost structure of the firms. It's something that comes from technology and, therefore, it affects the cost structure of the firm. Let's look at this graph here. So this is some capacity constraint situation in which assume that the market gives you a price p* like this is a reasonable price that this product is usually sold in the market. And your marginal cost looks like the blue curve there. This means that if the price is p*, then it makes no sense to you to try to produce more than this quantity q upper bar. If you produce more than this quantity, your cost will go up and you will start having losses from the production. In some cases, capacity constraints are still imposed by the cost structure but in a much more strict way like, for example, in this case that you have constant returns till the quantity q upper bar. And then after this, your cost goes to infinity because it's simply impossible to produce more than that. So you have technological reasons, there's not enough resources in order to produce it or something like that. So, for example, we cannot produce a million tons of diamonds every year. It will be impossible because the quantity that we can find is much smaller than that. So these are natural constraints that they are given by the cost structure. And then if you have capacity constraints, the thing is that the source of the Bertrand Paradox is hate in its root. What is the source of paradox again? That an incremental increase in price above competition results to a loss of your entire market share. But now with capacity constraint, this is not going to be the case anymore. Because charging more than the competition will in deed make you sell less but you are not going to lose all your market share. When your competitors sell to their capacity, you can cover the people that they were not able to shop from the cheaper competitor. So you will cover the residual demand yourself. This means that you lose share because the residual demand most likely will be smaller but with the moment, you can charge more the remainder of consumers that they didn't have time to shop there. So how does this work? How do we understand who is going to buy from whom? Assume that we have two sellers one is selling cheap and the other one is selling more expensive. You also have consumers, that consumers as you understand, they do not have the same willingness to pay. Some people need the product and like the product a lot and they're willing to pay a lot. Some other people just like the product or just they need it but they can also substitute it with something else and they're willing to pay less. Who is going to buy from the cheaper producer? Who is going to buy from the cheaper vendor? Should we assume that the people who need the product more will be the ones that they line up to buy the product? That's not necessary. Let's see now how rationing will affect the whole situation, how it's going to make every important difference, as we said. A reasonable question from what we said before is, who is going to buy from whom? Let's see how this indeed makes a difference from a very simple example. So you have four potential consumers that they are willing to pay for a product reservation prices. Reservation prices stands for how much at maximum you are willing to pay for a specific product, so this we call it an economics reservation price. So the first guy has a reservation price of 10, likes or loves the product a lot, is willing to pay up to 10 units for the product. Second person likes it a little less, willing to pay 6. The third person is willing to pay a little less 4. And then the third person doesn't like it that much willing to pay only 1 unit for this product. Maybe barely needs it, maybe kind of other substitute we don't know the reasons, we know that here evaluation is very small for this product. Now, you and your competitor are selling this product. And what's important now is that you have identical costs. It costs you 2 units to make this product. If we go back to the valuations we'll see that according to your cost, you don't want to serve the last valuation customer, this customer with the 1 valuation equal to 1. You don't want to serve this person because this will mean that you will be below your cost and you don't want to do that, this person is not willing to pay as much as the cost. Assumed also that you cannot serve both you and separately your competitor, you cannot serve more than two consumers each. So you have a capacity up to two consumers. You cannot serve three consumers. Assume also that your competitor charges a price, say 4. The question is, how much should you charge? Well, this will depend on the rationing, on who is going to buy first. For example, if your competitor serves the 10 and the 10 valuation consumers, then you should charge 4. Because this will give you a chance either to get the guy with a full evaluation so at least you're going to break-even. Or if it's simultaneously game it will give you a chance of equally opportunity of getting the 4, 6 and 10 consumer since you charge the same prices. So in this case you should charge 4. Now, if your competitor by charging 4 serves 6 and the 4 valuation consumers, then you could actually get away with charging 10. Because their residual demand is the highest valuation guy who maybe, let's say, is very wealthy, doesn't really like to go into lines. Would prefer in the end of the period and after everyone shopped to go to the most expensive vendor and buy their residual and doesn't care to pay that much. So in this case, you can even get away with charging 10. So you can see here that it depends on who is going to be served first and the result is going to change. Now, for some of these games there are ways to find equilibrium there are also other situations in which an equilibrium doesn't exist. You can have mix in a mix strategies or several equilibria can be possible. [MUSIC]

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